Step 11: Money and Banking

What money is: it is defined by what it does

Imagine there were no money. A baker who wants new shoes would have to find a shoemaker who happens to want bread at the same moment. Economists call this the double coincidence of wants, and it makes trade slow and costly. Money solves the problem: the baker sells bread to anyone for money, then uses that money to buy shoes from anyone.

Money is not defined by what it is made of. Banknotes, bank deposits and cigarettes in a prisoner-of-war camp have all served as money. What they share is what they do.

Inflation erodes money’s value, but its advantage is liquidity: how easily an asset can be turned into a means of payment without losing value. Money is perfectly liquid by definition.

Good money should also be durable, portable, divisible and limited in supply.

• Commodity money is made of something with value of its own, such as gold, silver, salt or cigarettes.
• Fiat money has no value of its own. It is money because the state declares it legal tender and everyone accepts it. All modern currency is fiat money.

Measuring the money supply

Central banks publish several measures, from narrow (most liquid) to broad:

• M0 (the monetary base): currency in circulation plus commercial banks’ reserves held at the central bank. Also called base money or high-powered money. This is the only money the central bank creates directly.
• M1: currency plus demand deposits and other chequable deposits. Money ready to spend right now.
• M2: M1 plus savings deposits, small time deposits and retail money market funds.
• Broad money: the widest measure, adding large time deposits and institutional funds. In the UK it is called M4.

In the UK in 2024, about 3% of money was physical cash; the other 97% was bank deposits. So almost all money is created not by the government but by ordinary banks.

How banks create money

The usual story is that banks take in savers’ deposits and lend them out. The chapter calls this backwards. When a bank makes a loan, it simply credits the borrower’s account with a new deposit. That deposit did not exist a moment before and was not taken from anyone. It counts as money because the borrower can spend it.

What limits this? Banks must hold reserves, either because the law requires it or because they need them to settle payments with other banks and meet withdrawals. The reserve ratio (\(r\)) is the fraction of deposits held as reserves. Under fractional reserve banking this fraction is well below one, and the rest can be lent.

The textbook model traces a chain. Suppose the central bank adds $1,000 of reserves and \(r = 10\%\). Bank 1 keeps $100 and lends $900. The $900 is spent and deposited at Bank 2, which keeps $90 and lends $810, and so on. The deposits form the series \(1{,}000 + 900 + 810 + 729 + \dots\), which adds up to $10,000.

In real life there are leakages. If the public holds a fraction \(c\) of money as cash, and banks keep extra reserves \(e\) above what they need (excess reserves), less is re-lent each round and the multiplier shrinks:

Banks, central banks and the interest rate

A bank’s balance sheet. A bank’s assets are what it owns: reserves at the central bank, loans and securities. Its liabilities are what it owes: mainly customer deposits, plus borrowing from other banks. Assets minus liabilities is capital, the owners’ stake.

This structure is fragile. Deposits can be withdrawn at any time, but loans are long-term: banks “borrow short and lend long”. If depositors believe others will withdraw, it makes sense for each to withdraw first, and the fear comes true. This bank run can bring down a bank whose loans are sound. In 2023, Silicon Valley Bank saw $42 billion withdrawn in a single day.

The central bank has four functions:

1. The only issuer of base money (currency and reserves).
2. Banker to the banks: it holds their reserve accounts and settles payments between them.
3. Lender of last resort: following Walter Bagehot’s 1873 rule, it lends freely, against good collateral, at a penalty rate, to a solvent bank facing a run.
4. It runs monetary policy (the next step).

The money market sets the nominal interest rate. Money demand slopes downward: holding money means giving up the interest you could earn on bonds, so when the interest rate rises, people hold less money. Money supply is set by the central bank and drawn as a vertical line. Where they cross is the equilibrium interest rate. If the money supply increases, the interest rate falls; borrowing gets cheaper, investment rises and AD shifts right.

Why the money multiplier is wrong

You must know the multiplier for your exam, but it largely misdescribes how banks behave. The textbook runs: reserves, then loans, then deposits. In reality the order is reversed. A bank lends when it finds a creditworthy borrower willing to pay the going rate, creating the deposit at the same moment. Only afterwards does it get the reserves it needs, borrowing them from other banks or from the central bank at the policy rate. Reserves follow lending; they do not cause it. The Bank of England said this in its 2014 article “Money creation in the modern economy”.

What really limits lending is: profitability (the loan must earn more than its funding cost and expected losses), capital regulation (since Basel III banks must hold equity capital against their assets) and the demand for loans (a bank cannot lend to people who do not want to borrow).

The evidence: between 2008 and 2015, quantitative easing (central bank asset purchases paid for by creating reserves) raised the US monetary base roughly fivefold. The multiplier predicted soaring money and inflation. Instead, M2 grew about 6% a year, banks held over $2.5 trillion of excess reserves, and core inflation averaged around 1.5%.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

Check yourself

The short version

• Money is defined by its functions: medium of exchange, unit of account, store of value. Modern money is fiat money.
• Measures run from M0 (cash plus reserves) through M1 and M2 to broad money. About 97% of UK money is bank deposits.
• Banks create deposits when they lend. The textbook multiplier is \( \frac{1}{r} \), reduced by cash and excess-reserve leakages to \( \frac{1+c}{r+e+c} \).
• Banks borrow short and lend long, so they are open to runs; the central bank acts as lender of last resort. A bigger money supply lowers the interest rate.
• In reality lending comes first and reserves follow. Quantitative easing after 2008 raised the base fivefold without raising inflation.

This guide covers the core of Chapter 26 of Economics Made Simple. For the full chapter, with the quantitative easing case study and 15 exam-style questions with a complete answer key, see the book.